What is 'bad bank' and can it resolve NPA woes?

NEW DELHI: After plunging to historic lows in Covid-hit 2020, the Indian economy is fighting back. The pandemic dealt a crippling blow to the economy, which suffered an unprecedented 23.9 per cent contraction in the April-June quarter.
But 2021 has started on a positive note.
The International Monetary Fund (IMF) has projected that India will reclaim the status of world's fastest-growing economy and has forecast 11.5 per cent growth this year.
The government has taken several steps to put India's Covid-hit economy back on track. But a lot more is expected in the Budget.
Finance minister Nirmala Sitharaman has already announced that Budget 2021 will be like "never before."
One of the key challenges that finance ministers over the years have faced is the increasing amount of bad loans of the banks - the non-performing assets or NPAs.
According to Reserve Bank of India (RBI) governor Shaktikanta Das, "Maintaining the health of the banking sector remains a policy priority and preservation of the stability of the financial system is an overarching goal."
The RBI in its Financial Stability Report has warned that the gross NPA ratio may increase from 7.5 per cent in September 2020 to 13.5 per cent by September 2021.
This will be the highest in more than 22 years and will put pressure not just on our banking system but also on the economy.
Several companies and millions of individual borrowers have been left struggling to repay loans due to the Covid-19 pandemic and the accompanying economic crisis.
This has led to a worrying surge in the NPA of banks, thus bringing them under severe stress.
When does a loan turn 'bad'
An asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank.
A ‘non-performing asset’ (NPA) was defined as a credit facility in respect of which the interest and/ or instalment of principal has remained ‘past due’ for a specified period of time.
The specified period 1995 onwards is two quarters.
So, what is the solution?
Several leading economists feel “bad bank” could be a good idea to free the banks from the mounting burden of the NPAs.
In May, the Indian Banks Association (IBA) had suggested to the finance ministry and RBI to set up a bad bank.
The Confederation of Indian Industry (CII) has also asked the government to consider “multiple bad banks" to address the NPAs of state-owned lenders.
CII President Uday Kotak feels the Covid-19 impact is expected to exacerbate the non-performing assets (NPA) problem, affecting the credit cycle. He suggests facilitating multiple bad banks, by allowing alternative investment funds (AIFs) to buy bad loans.
What is a bad bank
A ‘bad bank’ is a bank that buys the bad loans of other lenders and financial institutions to help clear their balance sheets. The bad bank then resolves these bad assets over a period of time. When the banks are freed of the NPA burden, they can take a more positive look at the new loans. Ideally, such a bank should be owned by the banks which have the most of NPAs.
Why should the government take the lead for bad banks?
Economic affairs secretary Tarun Bajaj has said all options, including establishing a bad bank, are under government’s consideration to improve the health of the banking sector.
The government needs to take the lead as it dominates the banking system in the country.
What do the RBI governors say on bad bank
Shaktikanta Das
"Bad banks have been under discussion for a long time, we are open to looking up any proposal on bad banks. It is for the government to come up with such a proposal, and if any, we will examine the proposal."
Former governor Raghuram Rajan
Former RBI governor Raghuram Rajan has also suggested the government to privatise select public sector banks (PSBs) and set up a bad bank to deal with NPAs and dilute the role of department of financial services.
In a paper co-authored by both Rajan and former RBI deputy governor Viral Acharya, both noted that the government obtains enormous power from directing bank lending. This power is sometimes exercised to advance public goals such as financial inclusion or infrastructure finance.
"Re-privatisation of select PSBs can then be undertaken as part of a carefully calibrated strategy, bringing in private investors who have both financial expertise as well as technological expertise; corporate houses must be kept from acquiring significant stakes, given their natural conflicts of interest," the paper said.
Mixed opinions
For post-Covid recovery, it is quite important that banks are free of their bad-loan burden. One of the ways to unburden it quickly is by selling them off to a bad bank.
Being one of the key drivers of economic growth, banks and financial institutions are the formal channels of credit.
With the pandemic crippling the earnings of businesses and individuals, thereby impacting their ability to repay loans in spite of the RBI's loan moratorium announcement, a bad bank may be able to provide some respite and enable restarting lending activities without fear.
However, there have been some different opinions on this too. In June last year, chief economic adviser (CEA) KV Subramanian had said that setting up of a bad bank may not be a potent idea as there are already many asset reconstruction companies (ARCs) in operation and banks have failed to sell bad loans to them. Also, when a bank sells bad loans it has to sell it at a discount and hence take a haircut.
Hence, it will be interesting to see if the Centre finally opts for setting up a bad bank in the system.